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Box 2. Mozambique 2009 FSAP Update—Key Recommendations

Measure Timeframe* Access to Finance Standardize bank fees, regularly consolidate and publish fee information Expand coverage and range of information collected by the credit registry, ensure legal framework allows private credit registries Short term Computerize and improve efficiency of property registry Review and improve transparency of court fee structure Enact financial reporting legislation covering regulatory aspects of accounting and auditing Medium Rationalize the regulatory framework for microfinance and develop a capacity building strategy term Discourage bundling of services by banks Banking System Soundness and Supervision Monitor international exposures and encourage banks to develop a stress testing framework Improve loan classification and provisioning rules and review banks’ impaired loan models Short term Introduce remedial action program Issue guidelines for banks on integrated risk management and supervision by risk Regulate and/or develop guidance on interest rate, country, liquidity, and market risk Strengthen crisis preparedness, including internal procedures on emergency liquidity assistance Ensure legal framework allows for flexible resolution tools, including partial purchase and Medium assumption or a bridge bank term Introduce deposit insurance after all preconditions are in place Strengthen cross-border collaboration with home country supervisors Money and Debt Markets and Liquidity Management Use overnight repos and reverse repos for BM short-term liquidity intervention Collateralize standing overnight deposit facility Short term Extend horizon of liquidity forecast to one year Increase stock of outstanding OTs through regular auctions; start issuing fixed rate OTs Medium Issue fungible BTs and OTs and reduce number of outstanding maturities term Pensions and Insurance Improve INSS governance through introduction of an IT system, publication of financial statements, and assessment of the value of investment portfolio Short term Publish outstanding regulations for all pension providers Test adequacy of financial resources, shareholders, and business plans of insurance companies Conduct actuarial study of INSS to determine whether parametric changes are necessary Adopt an explicit investment policy for INSS Medium Subject INSS and other pension providers to independent supervision term Improve frequency and coverage of data collected by IGS Payment System Complete the implementation of RTGS and monitor risks in the CEL Establish a payment system oversight framework Short term Introduce interoperability of cards and promote infrastructure sharing in retail payments Strengthen the staffing in the Payment System Unit Medium Establish rules for mobile financial services provision, especially payments term

* Short term: up to 12 months; medium term: 1–5 years.

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I. MACROECONOMIC CONTEXT AND MACRO-FINANCIAL LINKAGES

10. Mozambique’s economy is rich in natural resources, which are the main source of export earnings. A large aluminum smelter is Mozambique’s main exporter, accounting for almost half of total receipts, as well as a substantial portion of imports. Other important exports are electricity, gas, cotton, tobacco, and shrimp. Despite the importance of these sectors for foreign exchange inflows (both exports and foreign direct investment (FDI)), the linkages between the large exporters and the domestic economy are still relatively limited.

11. Since the 2003 FSAP, Mozambique’s economic performance has been strong. Macroeconomic stability, sustained structural reforms, substantial foreign aid flows and, until recently, a benign international environment generated an average annual real GDP growth rate of 7½ percent for most of the past decade. Although headline inflation was relatively high and volatile, underlying inflationary pressures were contained Table 1. The trade deficit has been high (with a spike in 2008 reflecting the world oil prices), but consistent with Mozambique’s stage of development and financed by non debt-creating capital inflows.

Table 1. Mozambique: Selected Macroeconomic Indicators, 2002–08

2002 2003 2004 2005 2006 2007 2008 Act. Act. Act. Act. Act. Act. Est. Real GDP Growth 9.2 6.5 7.9 8.4 8.7 7.0 6.8 CPI end-of-period, percent change 9.1 13.8 9.1 11.2 9.4 10.3 6.2 Current account balance, before grants, percent of GDP -19.2 -20.4 -14.6 -16.8 -15.4 -15.9 -20.4 Total net aid, percent of GDP 15.1 13.9 11.9 8.2 12.8 13.0 14.0 Private capital inflows, percent of GDP 19.1 7.7 2.7 2.6 2.7 5.7 4.0 of which: Foreign direct investment, percent of GDP 9.0 7.3 4.3 1.6 2.1 5.3 5.9 Gross international reserves, US$ million 825 947 1160 1103 1241 1520 1660 Months of import coverage 5.4 5.4 5.8 4.6 4.4 5.0 4.7 Percent of short-term liabilities 396 401 375 405 57 132 364 Broad money (M3), percent of GDP 27.3 32.4 26.6 28.6 29.7 32.4 33.7 of which: Currency outside banks, percent of GDP 3.5 4.3 4.1 4.0 4.0 4.3 4.0 Private sector credit, stock, percent of GDP 12.9 12.7 9.4 11.8 13.1 13.3 18.2 Foreign currency deposits, percent of total deposits 46.7 45.0 40.1 42.1 40.3 41.8 37.7 Foreign currency credit, percent of total private sector credit 45.9 56.3 58.4 46.7 29.3 24.4 31.6 Source: Mozambican authorities and IMF staff estimates and projections. 12. This performance largely reflects a prudent and successful macroeconomic strategy. Fiscal policy has focused on supporting priority social spending, maintaining debt sustainability, and limiting domestic borrowing in order to avoid crowding out the private sector. Monetary policy has been oriented toward price stability through reserve money targeting in the context of a relatively flexible exchange rate regime. Improvements in monetary management have helped reduce high and volatile real interest rates (identified as a major vulnerability in the 2003 FSAP), while foreign exchange rate operations sought similarly to limit excess exchange rate volatility. Development of the financial sector has advanced in line with a comprehensive financial sector strategy largely based on the 2003 FSAP recommendations.1 These policies have garnered substantial donor support and FDI.

1 The authorities, in collaboration with the World Bank, IMF, and donors, developed a comprehensive program supported by the Financial Sector Technical Assistance Project (FSTAP), a five-year project aimed at strengthening several aspects of the financial sector.

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13. Recently, however, the global financial turmoil has clouded the economic outlook and increased macro-financial risks. Box 3 discusses the possible transmission channels from the global turmoil to the domestic economy and financial sector and provides a prima facie assessment of the risks, pending the more detailed analysis in Section III. In summary, the Mozambican financial sector does not seem vulnerable to market and liquidity risks through direct financial linkages. However, given its reliance on commodity exports and external financing, the economy is now exposed to significant risk through real sector linkages. Lower growth in developed economies could affect Mozambique not only through lower external demand but also through declines in FDI and external aid flows, all of which would dampen growth prospects and increase credit risks for banks.

Box 3. The Global Financial Turmoil and Mozambique

The crisis could affect a financial sector like Mozambique’s through two major transmission channels:

Financial sector linkages (i.e., market risk, liquidity risk, and counterparty credit risk) ● Direct exposure of local banks to securities losses or to illiquid asset and funding markets. ● Exposure to counterparties’ with severe losses or illiquidity. ● Sudden stop of capital inflows, with repercussions for bank liquidity and market risk exposures. ● Contagion through parent banks' balance sheets (e.g., impairment of assets held with parents). ● Confidence shock to domestic depositors following bad news about a parent bank or of financial protectionism abroad (e.g., blanket guarantee of deposits in the developed markets).

Real sector linkages (i.e., loan portfolio credit risk) ● Domestic borrowers default due to a decline in income caused by a drop in external demand and/or in export commodity prices. ● Domestic borrowers default due to a sudden stop of capital flows and its impact on income, liquidity, interest rates, and exchange rates.

In the case of Mozambique, exposure to risk through direct financial linkages is low. Direct liquidity risk is limited, as domestic deposits account for more than 90 percent of liabilities for most banks and liquid assets cover more than 50 percent of deposits. Direct market and counterparty risks are also low, as banks’ securities portfolios are concentrated in treasury bills and deposits with their parent banks, which were not directly affected by the subprime crisis. The long position in foreign currency for the system as a whole and strict limits on net open positions for banks (less than 20 percent of own funds) protect against direct foreign exchange risk, while high provisioning requirements on lending in foreign currency to non-exporters limit indirect foreign exchange risk. And interest rate risk is limited by the preponderance of short-term and floating rate exposures.

The only possible exception is the risk of financial contagion from banks’ exposure to parents which, while very low, cannot be entirely ruled out. Foreign-bank subsidiaries in Mozambique have substantial foreign assets invested with their parent or related correspondent banks. Contagion from weak parent banks could take the form of direct pressures to transfer liquidity, or a rumor about a weak parent sparking a loss of confidence. These contagion channels, however, are constrained by capital controls and the current financial strength of parent banks, while associated risks are mitigated by the banks’ high level of liquidity. Furthermore, the BM’s gross international reserves far exceed banking system foreign currency deposits.

In contrast, Mozambique is very exposed to real sector linkages. Exports are highly concentrated and the economy is heavily reliant on aid and FDI. A sharp decline in export receipts and/or aid and FDI flows would translate into lower growth and increased credit risk. A major mitigating factor is that shocks propagated through this channel would take time to affect the banking system, providing borrowers, banks, and policy-makers leeway to adjust their business plans and policies.

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II. FINANCIAL SECTOR STRUCTURE AND PERFORMANCE

A. Structure, Depth, and Outreach

14. The financial sector is dominated by a few large, foreign banks (Table 2). Banks account for almost all the financial sector’s assets, and the 3 largest account for 85 percent of total assets. Almost all major banks are majority-foreign owned, either by Portuguese or other African banks (Table 3), although the government maintains participations in some. Microfinance institutions (MFIs) and micro-banks are small and not systemically important, although they have expanded rapidly in recent years (87 MFIs in 2008, up from 19 in 2003).2 This was largely the result of government initiatives to encourage the sector by lowering start-up capital and other costs, particularly in rural areas. However, like the commercial banking sector, the MFI sector is highly concentrated, with four MFIs controlling more than 60 percent of the loan portfolio. The pension sector remains dominated by the obligatory, state-run PAYGO system, although there are a few, small private corporate pension funds. The insurance sector is also small (with claims less than 1 percent of GDP), consisting of 5 private and one majority state-owned company. The stock market is in its infancy, with just 13 listed securities, of which only one is a company equity share.

Table 2. Mozambique: Financial Sector Structure

Dec-03 Dec-04 Dec-05 Dec-06 Dec-07 Latest 2008 1/ Number Total Assets Number Total Assets Number Total Assets Number Total Assets Number Total Assets Number Total Assets Percent of (Mln. Mt.) (Mln. Mt.) (Mln. Mt.) (Mln. Mt.) (Mln. Mt.) (Mln. Mt.) total assets

Commercial Banks 1/ 10 38,873,396 9 42,259,789 9 52,408,930 9 65,462,016 9 79,355,379 11 90,592,850 96.0 Private 10 38,873,396 9 42,259,789 9 52,408,930 8 65,125,037 8 78,934,392 10 90,170,189 95.5 Domestic ------1 596,518 0.6 Foreign 10 38,873,396 9 42,259,789 9 52,408,930 8 65,125,037 8 78,934,392 9 89,573,671 94.9 State-owned 1 336,979 1 420,987 1 422,661 0.4

Other depository institutions 6 818,796 7 1,454,655 8 1,673,586 9 2,261,082 10 2,983,278 10 3,084,431 3.3 Credit unions 4 709,264 5 1,142,876 5 1,203,293 6 1,351,930 6 1,446,809 6 1,202,734 1.3 Microfinance institutions 2/ 2 109,532 2 311,779 3 470,293 3 909,152 4 1,536,469 4 1,881,697 2.0

Total depository 16 39,692,192 16 43,714,444 17 54,082,516 18 67,723,098 19 82,338,657 21 93,677,281 99.2

Other credit institutions and financial companies 3/ 29 2,070,385 29 2,270,484 30 949,143 29 1,339,260 27 705,448 27 194,998 0.9 Investment Banks 1 63,985 1 51,749 ------0.0 Leasing companies 3 1,704,337 3 1,869,204 2 499,737 2 753,725 1 46,644 1 41,369 0.0 Finance companies 1 248,560 1 345,344 1 371,786 1 465,059 1 524,723 1 NA 0.6 Securities brokers 1 1,776 1 1,479 1 2,574 1 2,899 1 3,201 1 3,201 0.0 Others 2 2,332 2 933 2 9,906 2 14,781 2 15,364 2 6,912 0.0 Foreign exchange houses 21 49,395 21 1,776 24 65,139 23 102,796 22 115,516 22 143,516 0.2

Institutional investors 5 - 5 - 5 4,148 5 5,121 6 5,525 20 7,248 0.0 Insurance companies 5 - 5 - 5 4,148 5 5,121 6 5,525 6 NA 0.0 Pension funds NA NA NA NA NA NA NA NA NA NA 14 7,248 0.0

Total financial system 50 41,762,577 50 45,984,928 52 55,035,806 52 69,067,479 52 83,049,630 68 94,409,775 100.0 Sources: BM, MOF. 1/ 2007 data are used where 2008 data were not available. 2/ Excludes 3 banks focused on microfinance, which along with and 1 microbank are classified as microfinance depository institutions. 3/ Excludes non-depository MFIs as these are not required to report assets. As of 2008, there were 77 of these.

2 This number includes 77 non deposit-taking MFIs that are not included in Table 2, as they do not report assets.

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Table 3. Mozambique: Major Banks’ Parent Location, Participation, and Rating

Fitch 1/ Bank Main Shareholders Parent Participation Individual Long- Date Country Share Rating 2/ Term (percent) IDR 3/ 1 BIM - Banco Internacional de Banco Comercial Português Portugal 66.7 B A+ Dec. 01, 2008 Moçambique Government of Mozambique 17.8 2 BCI-Fomento Caixa Geral de Depositos Portugal 42.0 B AA- Oct. 29, 2008 Banco BPI1 Portugal 30.0 B A+ Oct. 3, 2008 3 Standard Bank, SARL Standard Bank South Africa 96.0 B/C A- Nov. 10, 2008 4 Barclays Absa Group Limited South Africa 80.0 B/C A Nov. 10, 2008 5 African Banking Corp ABC Holdings Limited Botswana 100.0 - - - 6 FNB FirstRand Group South Africa 80.0 B/C BBB Dec. 08, 2008 7 Mauritius Commercial (MCB) Mauritius Commercial Mauritius >70.0 - - - 8 ICB ICB Banking Group Switzerland 99.9 - - - 9 ProCredit 4/ Procredit Holding Ag Germany 85.5 C/D C/D Oct. 16, 2008 12 Oportunidade (BOM) 4/ Opportunity Transformation USA 59.9 - - - Investments Inc Source: Bank scope, Fitch and bank reports. 1/ Individual ratings attempt to assess how a bank would be viewed if it were entirely independent and could not rely on external support: B indicates a strong bank; C indicates an adequate bank, with no major concerns, but with one or more troublesome aspects; and D indicate a bank has weaknesses. 3/ Long-Term Issuer Default Ratings (IDR) provide an ordinal ranking based on Fitch's view of an issuer’s relative vulnerability to default. 4/ Focused on microfinance.

15. Despite the recent expansion in number and size of intermediaries, the depth of bank intermediation is not high. Both deposits-to-GDP and private sector credit-to-GDP, at 25 percent and 12.8 percent, respectively, appear to be around or slightly above the cross- country benchmarks calculated based on macroeconomic, population and structural variables.3 However, compared to the rest of the region, private credit-to-GDP ratio is below average and the loan-to-deposit ratio is particularly low, and up only marginally since the 2003 FSAP (Figures 1 and 2).

16. The outreach of the banking sector has expanded but access to financial services remains low and fragmented. The number of bank branches, automatic teller machine (ATMs), and point-of-sale (POS) has grown in recent years, especially in rural and peri- urban areas. But while large corporates have relatively good access to credit, SMEs and individuals do not (with the exception of salaried employees of corporations that use banks’ payroll account services). At 13 percent, the percentage of firms accessing lines of credit is not only low relative to other countries, but has declined from previous surveys in 2002 (29 percent) and 2005 (26 percent). Less than 6 percent of the adult population has credit from a registered financial institution, and just over 10 percent has a savings account.4 Rural

3 The model is based on Beck, T., E. Feyen, A. Ize, and F. Moiszeswicz (2008). “Benchmarking financial development,” World Bank Research Working Paper 4638.

4These estimates were based on credit account and savings account data from regulated institutions and microfinance operators as a proxy for the number of individuals served. Given that clients tend to have more than one deposit account, the number of deposit accounts was adjusted using BM data on deposit structure for unique clients for a sub-sample of financial institutions for 2007.

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populations remain particularly underserved: in 2008, branches in rural and peri-urban areas held roughly 20 percent of the number of savings accounts, even though these areas account for over 60 percent of the country’s inhabitants.

Figure 1. Mozambique: Private Credit Development Benchmarks, 2000–07

Private Credit to GDP 2007 Actual vs. Benchmark Private Credit to GDP

Mozambique 12.8 25 Zambia 10.1

Tanzania 12.1 20

Malaw i 6.2

Ke nya 22.4 15

Botswana 19.3 10 Angola 8.3

Sub-Saharan Africa 16.6 5 Low income 16.4

High income 105.8 0 2000 2001 2002 2003 2004 2005 2006 2007

Source: Bank of Mozambique and staff estimates.

Figure 2. Mozambique: Mobilization of Savings and Intermediation Efficiency, 2003–08 (In percent)

Actual vs. Benchmark Deposits to GDP Loan to Deposits

70% 30 60%

25 50%

20 40%

30% 15 20%

10 10%

5 0%

0 Q1-2003 Q3-2003 Q1-2004 Q3-2004 Q1-2005 Q3-2005 Q1-2006 Q3-2006 Q1-2007 Q3-2007 Q1-2008 Q3-2008 2000 2001 2002 2003 2004 2005 2006 2007 Source: Bank of Mozambique, Bankscope and staff estimates.

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B. What Holds Back Financial Intermediation?

17. Both economy-wide constraints and the financial sector structure explain the slow progress in financial deepening and financial sector outreach. Economy-wide structural and institutional impediments limit the number of creditworthy clients or increase the costs of extending credit or offering financial services. Specific structural characteristics of the Mozambican banking system hamper competition, reduce incentives to mobilize deposits, and contribute to high borrowing costs.

18. Economy-wide, structural impediments include:

• Poor physical access and infrastructure. Unstable electricity supply, poor road conditions, and distance from central bank offices deter rural branch expansion, along with difficulty finding skilled human resources.

• Weaknesses in the legal and regulatory framework. Despite recent improvements, enforcing a contract in Mozambique continues to be costly and slow.5 The arbitration center in Maputo—among the most efficient—processes less than 25 cases per year, and fees required to pursue a case are high. A draft bankruptcy law was submitted to Parliament, but has yet to be enacted.

• Weak financial reporting. Credit officers encounter difficulties in obtaining basic cash flow information from SME customers: information provided by smaller firms is often not supported by tax or other independent sources. All firms, including those with foreign participation, suffer from a serious shortage of qualified accountants.

• Problems with the credit and property information infrastructure. The BM’s credit risk bureau collects information on individual and corporate borrowers from the 21 regulated financial institutions, but its scope is limited, and it is designed primarily as a prudential monitoring tool. A private registry is currently under consideration, but it is unclear whether the current legal framework allows for private registries. The property registry is also limited—it is estimated that less than 30 percent of properties are registered—and antiquated—still paper-based and not linked electronically between major cities.

19. Structural characteristics of the banking system that impede financial intermediation include:

• Lack of competition. Industry concentration is high (Figure 3); the net interest margin, while declining steadily, is much higher than in comparable countries (Figure 4); and bank profitability is among the highest in the world, and has been steadily increasing since 2004 (Figure 5). These facts suggest lack of competition,

5 World Bank Doing Business Survey, 2008.

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Figure 3. Mozambique: Banking System Concentration, 2008

Selected market shares, by commercial bank Herfindahl-Hirshman industry concentration index

HHI - Loans 45% Share of loans 0.35 HHI - Deposits 40% Share of deposits HHI - Assets 35% Share of assets 0.3

30% 0.25 25% Concentrated 20% (<0.18) 0.2 15% Moderately 0.15 10% concentrated (0.1-0.18) 5% 0.1 0% Not BCI FNB BMI BIM

STB concentrated 0.05 ABC BBM MCB BOM (0.0-0.1) SOCREMO

PROCREDIT 0 Banco Terra 2003 2004 2005 2006 2007 2008

Source: Bank of Mozambique and staff estimates.

Figure 4. Mozambique: Banking sector efficiency benchmarks, 2000–07 (In percent)

Net-interest margin 2007 Actual vs. benchmark net-interest margin

Mozambique 9.8

Zambia 9.1 18

Tanzania 6.5 16

Malaw i 9.5 14

12 Ke nya 6.5 10 Botswana 5.2 8 Angola 5.5 6 Sub-Saharan Africa 6.8 4

Low income 6.3 2

High income 2.5 0 2000 2001 2002 2003 2004 2005 2006 2007 Source: Bank of Mozambique and staff estimates.

Figure 5. Mozambique: Banking Sector Profitability, 2004–07 (In percent)

Return on average assets (ROAA) ROAA for selected countries in 2007

3.7 3.5 Mozambique 3.5

Zambia 3.0

Tanzania 2.2

Malaw i 6.4 2.0 Ke nya 3.2 1.4 Botswana 1.8

Angola 3.4

Sub-Saharan Africa 2.4

Low income 1.9

2004 2005 2006 2007 High income 1.5

Source: Bank of Mozambique and staff estimates.

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which is corroborated by more formal tests, such as a Rosse-Panzar test;6 a BM study showing that lending rates of bigger banks tend to be responsive only to a market leader;7 and the analysis of the net interest margin and evidence of pricing power (below).

• High overhead costs. Overhead costs account for over half of the net interest margin (Figure 6) and are higher than other similar countries (Figure 7). High overhead costs can in turn be explained by high input costs (e.g., due to inflexible labor laws), absence of economies of scale, or lack of competitive pressures. The combination of high overhead costs and high profits is another indication of lack of competition.

• High bank commissions and fees. Reflecting lack of competion and economies of scale, commissions are pervasive, not transparent, high compared to peer countries (Tables 4 and 5),8 and some have more than doubled since 2003.9 The high costs imposed for account maintenance and the mandatory bundling of services by banks inhibit savings mobilization. Since savings serve as an entry point to credit access— banks typically require a savings history before extending credit—high fees also have a detrimental effect on credit expansion.

Figure 6. Mozambique: Total Ex-Post Interest Rate Margin Spread Decomposition, 2005–07 (In percent) Spread Decomposition 2007 Spread Decomposition 2005–07

100% 0.50 90% 80%

8.29 70% 7.9% 8.3% Tax 8.0% 60% Overhead 13.88 50% Reserve requirement 0.37 Provisions 2.20 40% Profit 30% 1.2% 2.2% 2.52 20% 1.5% 3.1% 10% 2.5% Tax 0.7% spread Interest 0% Overhead Provisions Reserve 2005 2006 2007 Profit margin requirements Source: Bank of Mozambique and staff estimates.

6 The Rosse-Panzar methodology uses the H-statistic, which measures the sensitivity of total revenue to changes in factor input prices (i.e., pricing power): in perfect competition (H=1); in a perfect monopoly (H<0)—see Panzar, John, and James Rosse (1987), “Testing for ‘Monopoly’ Equilibrium.” Journal of Industrial Economics Vol. 35, pp. 443–456). Mozambique’s H-statistic is around 0.3.

7 Bank of Mozambique Research Department, 2007, “Costs of financial intermediation versus profitability of the credit institutions,” Maputo.

8 USAID, 2007, “Financial Sector Constraints on Private Sector Development in Mozambique.”

9 Bank of Mozambique Research Department (2007), op. cit.

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Figure 7. Mozambique: Banking Sector Overhead Costs, 2004-07 (In percent)

Overhead Costs vs. Bank System Size, 2005–07 Mozambique Overhead Costs to Assets (BM), 2004–07 Overhead costs to total assets, 2005-07 6.5 12% 11% 10% 6.3 Mozambique 9% 8% 7% 6.1 6% 6.1 5% 4% 3% 2% 1% 0% 8 9 10 11 12 13 14 2004 2005 2006 2007 Log of bank assets, 2005-07 Source: International Financial Statistics, Bankscope, Bank of Mozambique, and staff estimates.

Table 4. Mozambique: Comparison of Selected Bank Commissions (In MT)

Commission Mozambique South Africa Botswana Mauritius Tanzania Cost of issuing 1 normal check 12.5 1.4 1.6 1.7 1.5 Cost of bouncing check 1500.0 268.7 994.3 173.2 820.1 ATM cash withdrawal 8.0 10.2 7.6 0.0 10.3 Interbank money transfer commission 500.0 35.8 104.8 0.0 130.9 Annual credit card fee 1820.0 394.0 381.0 86.6 380.0 Source: Bank of Mozambique Research Department (2007), “Costs of financial intermediation versus profitability of the credit Institutions” and staff estimates.

Table 5. Mozambique: Price Dispersion of Selected Commissions (In MT)

Commission Market minimum Market maximum General transactions Close account 50 1000 Consult balance at branch 7 25 Minimum balance violation 10 100 Dormant account penalty 58 615

Check transactions Issuance of normal check 2.97 12.5 Issuance of emergency check 35 572 Check deposit 150 337.5

Transfers Transfers within bank 11 85 Transfers between banks 100 500 Set up recurring transaction within bank 8 20 Set up recurring transaction between banks 135 260 Source: Bank of Mozambique Research Department (2007). “Costs of financial intermediation versus Profitability of the credit Institutions” and staff estimates.

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20. Removing these impediments to financial intermediation requires policy action across several fronts, much of which is already underway:

• On the legal and regulatory front, continue to encourage alternative dispute- resolution mechanisms and out-of-court settlements, the expansion of arbitration services, the establishment of a small claims court and, more generally, the strengthening and modernization of the judiciary, including a review of the court fee structure. The BM should clarify its requirements on mobile banking.

• To strengthen institutional infrastructure and information, the scope of the credit information should be expanded to cover a greater range of information and potential borrowers, and plans to modernize the property registries should be implemented.

• To improve financial reporting, new financing reporting legislation covering all regulatory aspects of accounting and auditing should be enacted, and the Commercial Code accordingly amended. Until the number of qualified accountants in Mozambique has reached a satisfactory level, restrictions on foreign workers in this area should be relaxed.

• Since there are no barriers to entry and the banking market is, in principle, contestable, competition in the banking system can be promoted chiefly through greater transparency on commissions and fees and unbundling of financial services offered by banks. Steps to enhance trading liquidity in the interbank market discussed in Section IV could also contribute to lower interest rates for customers.

21. These measures, however, will yield results only gradually. Many of the impediments reflect the economic realities in a developing country and can only be overcome in the long run. Others, like weaknesses in the property registry, accounting standards, or the judicial system, are already being addressed, but these efforts require time to generate tangible improvements. And the lack of competition in the domestic banking system is to a large extent the result of the small size of the market: as the market grows, competitive pressures will intensify. In the meantime, the best policy for the BM is to maintain macroeconomic stability, continue to strengthen supervision of the banking system, and ensure transparency and a level-playing field. The government should refrain from interfering in credit allocation e.g., through the recently-introduced direct lending scheme by districts.

III. BANKING SECTOR SOUNDNESS AND STABILITY

A. Financial Soundness Indicators and Risk Management

22. Since the 2003 FSAP, banks’ asset quality and profitability have improved substantially, although there are some exceptions. System-wide reported nonperformaing loans (NPLs) (as defined by BM regulations—see below) fell from 17.1 percent of total loans in 2003 to 2.8 percent at end-September 2008 (and an estimated 1.8 percent at year-end),

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largely reflecting the restructuring of problem banks and a major clean-up of balance sheets. The latter also resulted in a large jump in reported profitability ratios as bad assets were written-off capital reserves and banks’ losses reduced. At the same time, the dollarization of loans and associated foreign currency-induced credit risk declined, largely owing to the introduction of Notice no. 05/GBM/2005 that requires an initial 50 percent provisioning of foreign currency loans to non-exporters. Mozambican banks are also well capitalized: as of September 2008, all banks fulfilled the minimum required capital adequacy ratio (CAR) of 8 percent, with the average CAR at 13.8 percent of risk-weighted assets (Table 6). Against this overall positive picture, a few small and medium-size banks exhibit weaker asset quality, with NPL ratios twice as high as those of large banks and, in one case, significant underprovisioning.

Table 6. Mozambique: Financial Soundness Indicators, 2003-September 2008

2003 2004 2005 2006 2007 Sep-08

Capital Adequacy Regulatory capital to risk-weighted assets* 17.0 18.7 16.0 12.5 14.2 13.8 Regulatory Tier I capital to risk-weighted assets* 14.7 16.0 13.6 10.7 12.3 11.3 Capital (net worth) to assets** 1/ 8.0 8.3 7.9 8.8 9.5 10.9

Asset composition and quality Sectoral distribution of loans to total loans* Agriculture 12.7 9.5 8.5 6.4 9.4 9.0 Industry and tourism 16.9 11.9 16.8 22.2 19.5 20.0 Construction 5.2 3.4 4.1 5.6 5.7 4.5 Commerce 18.1 21.3 27.4 27.4 24.4 26.5 Transportation and Communication 7.1 7.2 5.8 6.2 12.2 8.8 Other Sectors 39.9 46.8 37.4 32.3 28.7 31.2

FX loans to total loans 69.3 64.2 53.6 34.3 29.6 33.8 NPLs to gross loans* 2/ 17.1 6.1 3.2 2.8 2.4 2.8 NPLs net of provisions to capital* 2/ 7.9 1.7 0.9 2.2 0.2 4.6

Earnings and Profitability ROA* 3/ 1.2 1.4 1.8 3.5 3.5 3.6 ROE* 3/ 16.3 18.7 27.4 55.4 47.7 44.3 Interest margin to gross income* 51.5 53.4 58.0 63.1 49.4 56.8 Noninterest expenses to gross income* 65.5 71.2 65.8 54.1 43.7 57.9 Personnel expenses to noninterest expenses 45.7 45.2 45.4 44.4 45.0 44.5 Trading and fee income to gross income** 34.6 29.5 35.0 32.2 47.5 43.1 Spread between reference loan and deposit rates (90 days local currency) 17.4 14.7 11.5 14.6 11.4 10.8

Funding and Liquidity Liquid assets to total assets*** (DAT-C) 57.7 58.1 55.5 51.9 55.9 55.9 Customer deposits to total (non-interbank) loans 251.9 243.6 189.5 180.5 191.2 183.6 FX liabilities to total liabilities 46.4 41.4 45.3 42.8 43.9 43.6

Source: BM and IMF staff estimates based on BM data. Notes: * Included in the "core set" of FSIs. ** Numbers subject to review. *** Includes deposits at parent banks. 1/ Net worth is defined as the difference between total assets and total liabilities. 2/ NPLs defined according to Mozambican regulatory standards. 3/ ROA and ROE for September 2008 are on annualized basis.

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23. The system is highly liquid and most banks are not exposed to much funding risk. Metical liquid assets10 cover 79 percent of short-term domestic currency liabilities, and foreign assets (mostly deposits at correspondent banks) cover 69 percent of foreign currency deposits. Most banks rely largely on stable retail or corporate deposits, while borrowed foreign funds are limited (less than 1 percent of total assets as of September 2008, much lower than in other countries in the region) as are domestic interbank market funds.

24. However, concentration risk is significant, as the number of creditworthy customers is limited. Lending is concentrated in a few sectors, such as energy and commodities. Though lower since the 2003 FSAP, when banks’ largest 3 borrowers accounted for more than 50 percent of total loans, concentration risk remains elevated: at some medium-size and small banks, the 20 largest borrowers accounted for as much as 85 percent of all loans at end-2008. While larger banks tend to have more diversified loan books (with the 20 largest borrowers accounting for almost 40 percent of all loans), they are exposed to concentration risk because they have substantial foreign assets deposited in parent or correspondent banks.

25. Loan classification and provisioning rules do not correspond to international best practice, although total provisions appear to be adequate. The NPL classification currently used in Mozambique departs from international best practice in two significant ways: first, it classifies as NPL for regulatory purposes only the amounts of principal and interest past due, rather than the entire loan outstanding; and second, it requires banks to classify as nonperforming all amounts past due for any length of time, even one day, rather than the 90 days typically used internationally. The first of these two factors tends to underestimate NPLs; the second tends to exaggerate them. Tentative staff estimates suggest that the quantitative impact of these factors is broadly equivalent, and the “true” level of NPL in the system is around 2.4 percent which, while higher than the reported end-year level (2.1 percent), is still relatively low. Moreover, specific provisions stood at 125 percent of the minimum regulatory requirement—although there was a significant dispersion among banks, with five banks failing to meet the minimum levels and two banks substantially underprovisioned. Finally, required general provisions are an additional 2 percent of loans.

26. Despite the apparent adequacy of provisions, loan classification and provisioning rules should be brought in line with international best practice and risk-based principles. As the above staff estimates are tentative and differences between banks are considerable, the current NPL definition hampers the assessment of the soundness of the banking system and of individual banks; it thus needs to be brought in line with international best practice (see also Basel Core Principles (BCP) assessment). Moreover, the loan classification uses only 3 broad timebands for provisioning of NPLs, with the first for payments overdue between 1–180 days. This does not provide sufficient differentiation for early warning of significant credit deterioration. Classification and provisioning rules should

10 Cash, deposits with the BM, short-term interbank loans, and treasury bill holdings.

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also be related to debtor repayment capacity (e.g., based on credit risk assessments), particularly in a system dominated by large corporate borrowers. While the additional 2 percent of general provisions help provide an extra buffer against credit risk, they are not risk-based and therefore distorts the cost of credit (lowering it for the riskiest borrowers and increasing it for the soundest borrowers).

27. Banks’ risk management is uneven and their ability to monitor and anticipate risks should be improved. Most large banks do some stress testing or risk sensitivity analysis of their exposures to liquidity or interest rate risks. The most advanced bank uses internal historical data to assess its liquidity risk, and the range of shocks it applies appears large but plausible. However, no bank reported stress testing their loan portfolio. Several banks were relying on the parent banks’ models and risk management, providing inputs for group stress tests. While these tests may be sophisticated, they may not adequately reflect Mozambique-specific risks, especially since the Mozambique subsidiary may be a small part of the group. The BM should encourage the development of better stress testing methodologies by banks. It should also build its own capacity—e.g., by collecting and analyzing data on sectoral exposures, probability of default, exposure at default, and loss given default— and review banks’ impaired loan models, in particular as it plans to move to Basel II.

28. There are pronounced weaknesses in certain microfinance institutions which, however, do not create systemic risk. Some MFIs and cooperatives have high levels of NPLs and some MFIs (mostly non-deposit taking) are not reporting to the BM as required. Moreover, minimum capital requirements for rural microbanks have been reduced to a level that is extremely low by international standards (MTN 750,000 or about US$50,000), which might encourage the emergence of unviable institutions. Although the systemic risk created by all these institutions is negligible, this situation can create market distortions and the BM should rationalize the regulatory framework for MFIs and develop a capacity building strategy to promote their sound development.

B. Analysis of Current Vulnerabilities and Stress Tests

29. Notwithstanding the overall resilience of the Mozambican banking system suggested by the foregoing discussion, banks are vulnerable to credit risk, especially in view of the global financial crisis. As discussed in Box 3, while the banking system is generally insulated from direct financial linkages risks, it is exposed to risk from real sector linkages. Stress tests have thus focused on credit risk, using both a macro-financial scenario analysis and an assessment of concentration risk, but also evaluate liquidity and exchange rate risks.11 Box 4 outlines the stress tests and methodology, and the detailed results are presented below and in Table 7.

11 Interest rate risk stress tests could not be conducted due to lack of data.

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30. The results suggest that the current level of capitalization of the banking system is sufficiently high to withstand most plausible macroeconomic shocks, although some individual banks would experience significant difficulties. The two scenarios lead to only a moderate decrease in capital adequacy, with CARs under the stand-alone and the combined aid, export, and FDI scenarios dropping to 13.1 percent and 12.6 percent, respectively. While the top three banks have adequate capitalization levels, some medium-size and small banks would be more affected. Under the combined shock, one medium-size bank would see its entire capital depleted, while two other banks’ CARs would fall below the required 8 percent minimum. The effects from the single export shock are more muted, with just two banks falling below the 8 percent threshold.

Box 4. Stress Tests: Assumptions and Methodology

Credit risk I: macro-financial scenario analysis To capture the possible effects of the global slowdown on exports and growth, two scenarios are considered (both as deviations from staff baseline projections for 2009): a p drop in total export receipts by 25 percent; and a simultaneous drop in exports, foreign aid, and FDI by 25 percent. The former would represent a major external demand shock, while the latter could be considered an extreme-but-plausible worst-case scenario. Only the direct impact on real GDP growth is taken into account, including the corresponcing drop in imports, though the second-round impact on domestic private investment and consumption is likely to be significant. Macroeconomic policies and key financial variables, such as interest and exchange rates, are assumed to remain unchanged. Using a simple macroeconomic accounting identity, the impact of the first shock is estimated to be a drop in real GDP growth by 3.4 percentage points on an annual basis, and the impact of the second is 5.6 percentage points. A quarterly regression of the change in the NPLs on real GDP growth and inflation for the period 2003-08 gives an elasticity coefficient for real GDP growth of -3.0, which is used to translate the decline in GDP growth into a deterioration in NPL.

Credit risk II: concentration risk These tests evaluate banks’ vulnerabilities stemming from high exposures to single obligors. Given the limitations of the large obligor data and the lack of information on current corporate vulnerabilities, the tests analyze the impact of default of each bank’s largest, 3 largest, and energy sector obligors.

Liquidity risk These tests evaluate banks’ liquidity risk by estimating the magnitude of deposit reduction (seperately for total and for private sector deposits) that would deplete completely banks’ liquid assets.

Exchange rate risk The tests assume exchange rate depreciations of 25 and 50 percent and evaluate the impact of an exchange rate shock on banks’ capital adequacy, taking into consideration the magnitude of net foreign currency exposures. The former is broadly in line with observed 12-month percent changes since 2002 (about 30 percent), while the latter is an extreme-but-plausible scenario.

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Table 7. Mozambique: Summary of Stress Test Results Banking System Top 3 Banks Medium-Sized Banks Small Banks

Banking System Structure (before shock) Number of Analyzed Banks 1/ 12 3 5 4 Assets (mln MT) 90,722 74,730 14,111 1,882 Assets/System Assets 100.0 82.4 15.6 2.1 Regulatory Capital (mln MT) 7,394 5,675 955 764 CAR 14.4 12.8 23.8 27.0 NPL 2.1 1.2 8.8 4.5 Underestimation of NPLs: Correction NPL 2.4 1.1 12.1 6.4 Underprovisioning: Full Compliance with Provisioning Rules (before shock) CAR 13.8 12.7 17.9 25.1 CREDIT RISK (Over 6 quarters) Stress Scenario 1: Simultaneous Aid, Export and FDI shocks CAR 13.5 12.2 19.7 25.2 Min CAR -0.4 10.0 -0.4 4.4 Max CAR 86.8 14.4 86.8 77.8 NPL 2.5 1.1 12.7 6.4 Stress Scenario 2: Export Shock CAR 13.1 12.4 13.9 23.6 Min CAR 6.1 10.2 6.1 7.4 Max CAR 87.1 14.6 87.1 77.8 NPL 2.5 1.1 12.7 6.4

CONCENTRATION RISK Stress Scenario 1: Default of largest obligor per bank CAR 7.8 7.0 9.5 24.3 Min CAR -1.8 4.1 -1.8 12.4 Max CAR 84.5 9.1 84.5 72.7 NPL 9.1 7.9 19.1 11.1

EXCHANGE RATE RISK Stress Scenario 1: 25 percent depreciation against theUSD CAR 14.3 13.5 19.2 20.2 Min CAR 10.7 10.7 11.1 11.0 Max CAR 77.8 15.1 77.8 30.2 Capital Loss/ Gain (in % of Capital) 6.0 6.4 7.6 -0.2 Stress Scenario 2: 50 percent depreciation against the USD CAR 15.1 14.3 20.6 20.2 Min CAR 9.6 10.4 12.6 9.6 Max CAR 77.9 15.5 77.9 31.7 Capital Loss/Gain (in % of Capital) 12.0 12.7 15.3 -0.4

LIQUIDITY RISK 3/

Liquid Assets (mln MT) 4/ 27,971 22,530 5,210 231 Liquid Liabilities (mln MT) 35,304 29,428 5,365 511 Liquidity Ratio 5/ 79.2 76.6 97.1 45.2

Stress Scenarios: Size of deposit decreases that lead to complete depletion of liquid assets. Size of a general deposit decrease 42.3 40.7 54.2 20.3 Size of decrease of private sector deposits 6/ 77.5 76.9 81.8 55.5

Source: IMF staff estimates based on data from BM. 1/ Due to data constraints, the number of analyzed banks for exchange rate risk is 11 (incl. 3 small banks) 2/ As of September 2008. 3/ Liquid assets include cash, deposits with BoM, domestic and foreign short-term interbank deposits and T-Bills; Liquid liabilities include resources of central banks, short-term deposits and short-term loans from other financial institutions. 4/ The liquidity ratio is defined as the ratio of liquid assets to liquid liabilities. 5/ One bank has a liquidity ratio over 1, precluding depletion of liquid assets as a result of the assumed shock.

31. The default of the largest borrowers would be problematic, given banks’ concentrated credit portfolios. A stress test of the default and complete write-down of the single largest borrower of each bank shows the system-wide CAR falling to 7.8 percent, with three small and medium-size banks under the minimum capital requirement. The default of the three largest obligors would deplete the capital base of these banks; however, simultaneous failure (and full loss given default) of the largest borrowers across several industries is an extremely low probability event. A more industry-specific shock that assumes the failure of all energy companies among the three largest bank obligors would be more manageable, with the system-wide CAR decreasing to 9 percent.

32. The system is resilient to liquidity and exchange rate shocks. However, some tests were constrained by data deficiencies.

• The stress test for liquidity risk estimates the drop in deposits that would deplete the system’s liquid assets in the absence of generally accepted liquidity ratio benchmarks. Since the system is very liquid, this drop would need to be very substantial (around 40 percent). The test results suggest that liquidity risk is low, although the variation across bank groups shows that small banks are more sensitive.

• Direct exchange rate risk test assess the impact of exchange rate shock on banks’ net open position in foreign currency and capital adequacy ratios.12 Most banks, except for some small banks, are long foreign exchange and would not suffer valuation losses. Indirect foreign exchange credit risk is also limited due to the provisioning requirements on foreign currency loans to non-exporters, which induces banks not to lend to unhedged borrowers.

IV. BANKING SUPERVISION AND FINANCIAL SAFETY NETS

A. Banking Supervision

33. The supervisory framework and capacity have been significantly enhanced since the 2003 FSAP. Key enhancements include a major revision to the Banking Law; introduction of rules for consolidated supervision; a new inspection manual; promulgation of the AML law; and the implementation of IFRS for banks. Home-host supervisory relationships were also strengthened, either through Memoranda of Understanding (MOU) or informally. Furthermore, Bank Supervision Department, BM (BSD) staff has increased substantially and great emphasis has been placed in training programs.

34. Today, the BM seems to have a good overview of the Mozambican banking sector as a whole and of individual institutions, but the structure of the system presents

12 Lack of information on banks’ off-balance sheet exposures hampers the analysis of their overall net open position, but given Mozambique’s relatively low level of financial sector development, these exposures are likely small.

important challenges. Regular reports and analysis of the financial situation help provide an up-to-date view of each institution, and more detailed insights are acquired through yearly on-site inspections. However, the structure of the Mozambican banking system presents two particular regulatory challenges for the BM. As discussed in Section II, banking system assets are highly concentrated in the four largest banks, all of which are foreign-owned. This implies that first, the BM needs to have strong cross-border collaboration with home country supervisors; and second, in collaboration with home country supervisors, the BM needs to review systems developed at the parent company and determine their applicability and adequacy for the Mozambican branch or subsidiary.

35. The enhanced framework is evidenced in the improved BCP assessment, although shortcomings remain. The BCP Report on Standards and Codes (ROSC) documents the significant progress made since 2003 —Appendix I. Despite this progress, important shortcomings remain, especially in the areas of loan classification and provisioning, assessments for risks other than credit, and remedial action.

• Loan classification and provisioning. As discussed in Section III, loan classification and provisioning rules should be brought in line with international best practice and be made more risk-based.

• Risk monitoring and management. In contrast to credit risk, interest rate, country, liquidity, and market risks are either not regulated or regulations do not always include guidance for supervisors in monitoring compliance or provide banks with the minimum requirements expected for risk management systems. Although these risks are currently low, these weaknesses should be addressed.

• Prudential regulations. The BM is in the midst of developing a significant amount of guidance to enhance its supervisory process, procedures for monitoring compliance with AML requirements, and guidelines on internal audit. This would also include guidelines on integrated risk management and risk-based supervision. These efforts need to be brought to fruition as soon as possible.

• Remedial action. Although the BM has adequate legal powers to take action in case of banks in difficulties, these powers are not always used effectively, undermining credibility. While minor remedial actions are always taken, the BM is occasionally slow to act when important problems occur, such as insufficient capital or inadequate provisioning. An effective remedial action program, along the lines presented in Annex II, can instill discipline and make remedial steps more systematic and credible.

• Foreign supervisory coordination. The BSD should be familiar with the home country supervisor, the strength of support that may be available from the parent company, the home country rules for bankruptcy, and economic conditions in the home country. With the planned global implementation of Basel II, the BM will need to ensure it is familiar with capital allocations to the Mozambique operations.

Monitoring risk in the concentration of correspondent deposits in parent banks is another area that requires coordination and familiarity with country risk.

36. The BM should ensure that adequate resources are dedicated to reviewing compliance with IFRS and the completion of the supervisory guidance. It should continue to strive for up-to-date training and adequate of human resources in the BSD, and ensure that supervisory capacity is adequate to supervise the expansion of credit institutions to remote geographical areas. Furthermore, given the weak accounting and auditing environment, the BM should ensure capacity exists to monitor and enforce IFRS requirements, as well as to deal with reconciling IFRS and prudential requirements (as recommended by the 2008 Accounting and Auditing ROSC).

B. Financial Safety Nets

37. The planned deposit insurance scheme should not be introduced before the key preconditions are in place. The BM has drafted a deposit insurance fund (pay-box) proposal, currently being reviewed by the government, with a view to having it approved by year-end. In broad terms, the key elements of this proposal appear to conform to best practice.13 However, before the authorities approve it, they should conduct a thorough assessment of the proposed scheme against the International Association of Deposit Insurers core principles. More importantly, since a DIS can increase moral hazard and the contingent liabilities of the government, the authorities should ensure that the preconditions for a sound scheme are in place before it is introduced, notably no pre-existing problem institutions; effective supervision; and strong remedial action and resolution frameworks.

38. Although key components appear to be in place, the entire crisis management and bank resolution framework needs to be carefully reviewed.

• The framework for supervisory administration and bank liquidation may need to be clarified. The banking law allows the BM to designate an administrator (and remove the banks’ management if necessary) to restructure a problem bank, and the bank liquidation law allows it to initiate administrative liquidation to sell-off its assets. However, neither the timeframe nor the criteria for initiating liquidation are sufficiently clear.14 Moreover, the authorities’ ability to create a bridge bank or do a timely partial purchase and assumption is questionable: it would take a long time to verify liabilities, and it is not clear whether the current legal framework allows differential treatment of creditors, which may be needed for a successful resolution.

13 The FSAP mission received only an executive summary of the proposal and did not discuss in detail all technical aspects that would be required for a full assessment. Elements in line with best practice include mandatory participation of supervised banks, exclusion of related-party deposits, partly risk-based premia).

14 This is also related to the lack of an effective remedial action framework.

• The BM should consider a comprehensive and explicit emergency liquidity assistance (ELA) framework. The law grants the central bank the power to provide liquidity assistance for up to 180 days; discount short-term securities (e.g., trade credits); and give credit against a limited range of collateral, e.g., mostly government securities.15 However, the BM has only established an overnight standing facility (FPC). An explicit ELA policy would specify the principles and procedures to be followed in case of an acute liquidity problem in normal times (assistance to be given only to illiquid but solvent banks, against adequate collateral, and as a last resort), as well as in case of a critically undercapitalized but systemically important bank, or in a crisis.

• The authorities should develop a crisis management plan, in particular for systemic banks. The authorities should review the legal framework to ensure they have effective powers and procedures for the failure of a large, systemically important bank, including addressing specifically the issue of public funds and coordination with foreign supervisors, central banks, and treasury authorities. In cooperation with the Finance Ministry, the BM should develop contingency planning and testing.

V. CENTRAL BANK OPERATIONS, MARKETS AND PAYMENTS INFRASTRUCTURE

A. Financial Markets and Central Bank Operations

39. Deep and liquid money and public debt markets are important for monetary stability and financial intermediation. At the time of the 2003 FSAP, high and volatile interest rates and weaknesses in the monetary policy framework threatened monetary stability and the development of the financial sector, encouraged dollarization, and raised the cost of domestic public debt. Since then, major progress has been made in these areas, as evidenced by the successful introduction of a monetary targeting framework and market- based instruments; the growth of the interbank market; the gradual liberalization of the foreign exchange market, new regulations, and Code of Conduct for participants; advances in de-dollarization; and the reduction in inflation, interest rates, and interest spreads. Positive signs have also arisen lately in the area of public debt management, such as a successful bond issuance in 2008 and the preparation, for the first time, of an Annual Report on Public Debt.

40. But Mozambican financial markets are still thin and operate under the constraints implied by the structure of the financial system and the monetary policy implementation framework.

15 Acceptable collateral is gold and domestic and foreign government or government-guaranteed securities, in domestic or foreign currency, quoted on the stock exchanges of the principal financial markets.

• The interbank money market (MMI) and the treasury bills (BT) secondary market are the only markets showing some activity.16 But even those are very shallow: the BT secondary market had 147 transactions in 2008, totaling MT 4.5 billion; the interbank money market was more active, with MT 52 billion traded (Figure 8). The market for government OT is small and illiquid: only sixteen trades were recorded in 2008, totaling MT 300 million. Custody of OTs is provided by the stock exchange (BVM) in dematerialized form, but Mozambique Stock Exchange (BVM)’s computers are not connected to those of the BM, where the RTGS system and the custody system for BTs run. This prevents delivery-versus-payment (DVP) in OT transactions and makes it harder to use these bonds for repos.

Figure 8. Mozambique: Monthly Number of Trades and Amount Traded in MMI (MT million)

250.0 12,000.0

10,000.0 200.0

8,000.0 150.0 6,000.0 N. trades Amount 100.0 4,000.0 50.0 2,000.0

- - Sep-06 Jan-07 May-07 Sep-07 Jan-08 May-08 Sep-08 Jan-09 Source: Bank of Mozambique.

• The only instrument the BM uses for liquidity injection is the FPC, which is seen by the market as a ceiling for BT auctions. In a very concentrated market and in the absence of a deep secondary market, such a ceiling leads to distortions in the behavior of primary auction rates (Figure 9). Moreover, the absence of a liquidity provision instrument at market rates induces banks to hoard liquidity, reducing the chances that complementary positions appear in the money market. Banks spread out their holdings of BT so that almost every week there are bills coming due; temporary excesses are placed in the standing deposit facility (FPD), in amounts which, although

16 The stock market is still in its infancy. Just thirteen securities are listed in the stock exchange: five treasury bonds (total amount MTN 3 billion) and seven corporate bonds from five companies. Only one company has listed shares. There are no active mutual funds or brokerage houses—brokers in the stock exchange are the biggest banks. Despite efforts to develop the private pension fund industry, its presence in the market is still very limited. Capital controls prevent foreigners from entering the market.

small when compared to BTs, are equivalent to 20 percent of bank reserves and have been growing recently.

• Liquidity forecasting is excessively focused on the short term. The BM is currently undertaking two forecasting exercises: one conducted by the Markets Department (DEM) on a daily basis and focused on one maintenance period of required reserves; and the other performed by the Economic Studies Department (DEE), with a 3-month horizon, providing guidance to the DEM on its interventions for structural liquidity management through sales of BT and foreign exchange. There is no regular longer- term liquidity forecasting exercise.

41. The key policy challenge here is to improve trading liquidity. First, more trading liquidity would mean greater facility changing assets for cash or financing those assets through repos. Second, it would help reduce interest rates through the decrease of the liquidity premium. And third, it would provide the basis for a market-based yield curve. A market yield curve, in turn, is key for the development of capital markets and for efficient monetary policy transmission. Steps to improve trading liquidity fall into two categories.

Figure 9. Mozambique: Interest Rates, 2007–09

FPC 16

14 BT364

BT91 MMI 12 MMI Rev repo 7

FPD 8

6 1/2/2007 4/2/2007 7/2/2007 10/2/2007 1/2/2008 4/2/2008 7/2/2008 10/2/2008 1/2/2009

Source: Bank of Mozambique.

Central bank liquidity management

• The medium-term liquidity exercise needs to be extended to one year. For one or two quarters, base money has to be forecast from current and past conditions; only for longer periods, the base money target—and other monetary program targets—can be treated as an input. Forecasts of government flows should be coordinated with monthly or—at least—quarterly reviews of the plan prepared by the Treasury for the fiscal year. BT issuance should be based on this exercise and be consistent with the estimated evolution of the rest of BM’s balance sheet. As confidence in medium-term forecasting builds up, a BT auction schedule—with dates, maturities, and amounts— should start being published regularly, to allow investors to better plan their participation. When setting up this schedule, the BM should space out auctions for the same term, thus helping increase competition in those auctions.

• The implicit ceiling for BT auction rates should be removed. While the FPC should continue to function as a ceiling for the very short-term interest rates, the longer-term rates should reflect market expectations. The BM would still be able to deal with instances of oligopolistic behavior by rejecting part or all of the bids in an auction. (although the number of such events should be kept to a minimum). The BM should not open a second auction when demand is greater than the amount offered: the unattended bids will add to demand in subsequently scheduled auctions.

• The BM should use overnight repo and reverse repo auctions for intervention, guided by the short-term liquidity forecast. In both cases, the intervention should have a one-day term and its cut-off rate be close to the interbank overnight rate. Banks’ confidence that BM stands ready to inject liquidity at reasonable rates in the event of an aggregate shortage should motivate them to reduce their liquidity cushions, facilitating the development of the money market.

Market development

• To encourage the use of repos among market participants, the BM could collateralize the FPD.17 This would allow a bank to intermediate liquidity excesses of other counterparts—that may or may not have an account with this bank—towards the central bank deposit facility.

• Both the BM and the MOF should start to issue fungible securities,18 thus reducing the number of outstanding maturities. This is a way to start creating market benchmarks with higher outstanding volumes, which will tend to be more liquid than

17 To this end, the BM’s holdings of perpetual government bonds could be swapped with marketable instruments.

18 Fungible securities have identical face value, coupon value, maturity date, and coupon payment dates.

many different bills and bonds with low outstanding volumes. It would also allow regular auctions without an excessive number of different securities outstanding.

• Information on public debt should be improved through the publication of a consolidated BT/OT issuance calendar, information on outstanding debt, and data on primary and secondary market trading.

• An increase in the stock of outstanding OTs would stimulate market development without increasing the net public debt if the proceeds are not spent. The amounts issued at BT auctions could then be reduced, intensifying competition for those instruments. Moreover, issuing fixed instead of floating rate bonds would provide the basis for lengthening the yield curve beyond one year.

• A number of measures should also be considered to strengthen custody, settlement, and trading arrangements, notably creating conditions for trades to take place between a bank and a client of another bank; ensuring DVP settlement of transactions originated at the Stock Exchange (see following Section); and unifying BT and OT custody.

B. Payments System

42. Since the 2003 FSAP, Mozambique has made considerable progress in improving its national payments system. Mozambique introduced the government electronic funds transfer system (EFTS) in 2004, which replaced the non-encoded payment orders and Titulos transactions that were previously processed through the CEL system; upgraded the CEL system to allow for electronic clearing by its 17 participants; promulgated the National Payment System (NPS) Act in October 2007; strengthened the regulations for interbank clearing and settlement; introduced the Sistema de Transferencia de Fundos do Estado (STF)—a real-time system used by Government for payments, including salaries for the civil service; and although still inadequately staffed, the Payment Systems Division now has a staff complement of six, an improvement from the two staff manning the Unit in 2003. In addition, the 2007 NPS law strengthened the legal basis for the payment system and paved the way for the introduction of RTGS.

43. Today, pending full implementation of RTGS, the CEL remains the main settlement system, with the BM providing settlement arrangements for participants. The CEL system is still used to settle obligations arising from the cheque payment stream, government EFTS, ATM, and POS networks, and the stock exchange (BVM). Using seven branches and the head office in Maputo, the BM facilitates the clearing of cheques and the distribution of cash throughout the country. Although cheques and electronic fund transfers are the main means of payment, cash still accounts for a significant proportion of payment transactions and banking costs.

44. In this transitional phase, the key priority is to continue to monitor the risks inherent in the CEL system and complete the implementation of RTGS. CEL operates on